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Comments on Proposed 2704 Rule Change

On August 2 the US Department of Treasury proposed changes to the way estates are valued in what is known as section 2704(b).Public comment is being sought through November and a public hearing will take place in December 1 in Washington, DC.

The Forest Landowners Association is supporting 2 bills in Congress aimed at stopping the proposed rule changes, working with partner associations and Congress on letters to Treasury highlighting the negative impact of the changes to landowners and will provide direct comments and testimony during the comment period and public hearing.

BACKGROUND

Many families that have real estate assets place these assets in a family owned company which serves multiple purposes, gifting shares in a company, providing a means of involving second or third generation family members in the business and facilitating orderly day to day management.

Company valuations (appraisals) are often needed to provide shareholders values for a financial statement, loans, property sales or exchanges, or transferring to the next generation by gift or inheritance.

The object of these valuations is to determine fair market value. Determining fair market value for real estate is developed by three approaches: comparable sales, income (discounted cash flow analysis) and summation approach or sometimes called “sum of the parts”.

If assets are in a company, fair market value is determined by the value of the company’s stock or shares. The appraiser must first consider the nature and value of all assets in the company before attempting to value the fair market value of all company shares.Typically, the fair market value of shares held in closely held company, like many family forest landowners, will sell at a price less than the simple prorate percentage of ownership that someone might hold. This ratio has evolved to be expressed as a “discount”.While the term “discount” is a misnomer, it’s a convenient way for appraisers to illustrate the relationship between share price and the sum of the assets. Historically, stock/share prices for timberland companies, whether public traded or closely held companies, typically sell at something less than the sum of values for the land and crop, i.e. shares sells at a “discount”. Nevertheless, the appraisal process leads the appraiser to a fair market value conclusion.

In the 2704 proposed rule changes, the appraiser will be forced to value based on a prorate share of the value established by “sum of the parts” or the income approach, but excludes the comparable sales approach. Requiring such valuation/appraisal, is totally contrary to long held appraisal principles and will result in imposing a value that may have no relationship to “fair market value”, a willing buyer-willing seller approach to value. “Fair market value” will be deemed to be “sum the parts” without consideration for the fact that it is actually stock or shares being valued. Abandoning such long held principles will create an artificial value not in relationship to the marketplace.

ILLUSTRATION

4000 Acres Land @ $1000/acre = $4,000,000

4000 ac Timber value@ 1500/acre= $6,000,000

Sum of Values ………………………$10,000,000.

Assume this asset is held in a closely held family company with 100,000 shares of outstanding stock issued.

$10,000,000 / 100,000 shares issued = $100 per share

Owner A - 30,000 shares x $100/share = $ 3,000,000

Owner B - 20,000 shares x $100/share = $ 2,000,000

Owner C - 50,000 shares x $100/share = $ 5,000,000

While the sum of the parts (for the assets) indicates a value of $5 million for owner C,

the 50,000 shares of stock will have a market value at something less than $5 million. Why?

Because of illiquidity and lack of control there is no quick and ready public market for these shares. A typical buyer with $5 million in hand would typically prefer to buy his own land and have complete control. But, there is a price that would make the purchase attractive. Let’s assume that he is willing to pay $2.5 million.This can be translated to a 50% discount to the “sum of the parts value”.

In reality, buyer discounts for such purchases reflect a 30% to a 70% “discount”. In reality, if the IRS 2704 proposed changes are allowed to be implemented, fair market value ($50/share), a long held principle in all trade and in all appraisals, must be abandoned in favor of summing the parts ($100/share).

This proposed valuation requirement will approximately double estate tax valuations for timberland owned by closely held companies, a devastating effect on timberland owners across the country.